CASH ACCOUNTING VS. ACCRUAL ACCOUNTING
We will discuss these each in depth – but remember the basics of the two principal methods of keeping track of a business’s income and expenses: cash method and accrual method (sometimes called cash basis and accrual basis). In a nutshell, these methods differ only in the timing of when transactions both sales and purchases are credited or debited to your accounts.
If you use the cash method, income is counted when cash (or a check) is actually received and expenses are counted when they are actually paid.
If you use the accrual method, income is counted when the sale occurs, and expenses are counted when you receive goods or services you don’t have to wait until you see the money or until you actually pay money out of your checking account. But, under the more common accrual method, transactions are counted when they happen regardless of when the money is actually received or paid.
The cash and accrual methods can produce the same results. The two types will only be different if you do some transactions on credit. If all your transactions are paid in cash as soon as completed, including your sales and your purchases, then your ledgers will look the same regardless of what method you use. In our Ag-community, this becomes an impossibility.
Income and expenses must be reported to the IRS for a specific period of time, called your tax year, your accounting period or your fiscal year. But unless there is a valid business reason to use a different period, or unless your business is a corporation, you’ll have to use the calendar year, beginning on January 1 and ending on December 31. Most business owners do use the calendar year for their tax year, simply because they find it easy and more natural to use. If you do want to use a different period, you must request permission from the IRS. Also, your fiscal year can’t begin and end on just any day of the month; it must begin on the first day of a month and end on the last day of the month one year later. Sometimes this different beginning and ending will fit our agricultural businesses better than year end date.
The most significant way your business is affected by the accounting method you choose involves the tax year in which income and particular expense items will be counted. For example – if you incur expenses in the 2012 tax year, but do not pay them until the 2013 tax year, you won’t be able to claim them in 2012 if you use the cash method. But as you should now understand, you would be able to claim them if you use the accrual method, since the very essence of that system is to record transactions when they occur, not when money actually changes hands.
Whichever method you use, it is important to realize that either one only gives you a partial picture of the financial status of your business. While the accrual method shows the ebb and flow of business income and debts more accurately, it may leave you in the dark as to what cash reserves are available which could result in a serious cash flow problem. And though the cash method will give you a truer idea of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. To have a firm and true understanding of your business’s finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to be able to answer specific financial questions. After all, this is your business! It is vital that you understand every aspect of its workings.